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					Accounting for Leases

        ACCTG 5120
        David Plumlee



                        1
What is a Lease?
“ A lease is a contractual agreement
  between a lessor (owner) and a lessee
  (renter) that gives the lessee the right
  to use property owned by the lessor for
  a specific period of time in return for
  rental payments.”


                                      page2
     Accounting for Leases

Before 1976 most leases accounted for leases as
  rental agreements. Why was this accounting
  found lacking ?


 Over time lease agreements began to
 resemble installment purchases where
 Companies were in effect borrowing
 money to buy an asset
                                                  page3
     Classification of Leases
What is the economic nature of a capital lease?
 One that transfers substantially all the risks and
 benefits of ownership to the lessee.

What is the economic nature of an operating lease?
 One that does not transfer the risks and
 benefits of ownership to the lessee;a rental
 agreement
                                                      page4
        Accounting for Capital Leases
   Accounting reflects economic substance,
    not legal form

   Make it appear as though company
    purchased an asset with borrowed funds
       an asset and an obligation
       interest expense on obligation
       depreciation on asset
                                              page5
    Is this a Capital Lease?
Does it meet ANY ONE of the four criteria?
 •Lease transfers ownership of asset
   •automatically by end of lease term or
   •through a bargain purchase option
 •Lease term is at least 75% of asset’s estimated
 economic life
 •PV of minimum lease payments is at least 90% of
 asset’s fair market value at beginning of lease term
                                                    page6
    Minimum Lease Payments
    Leases without a BPO
   Minimum rental payments plus
   Any guaranteed residual value plus
       amount the lessee guarantees lessor will realize
        on the asset at the end of the lease term
   Penalties for failure to renew lease if at the
    beginning of lease term renewal does not
    appear to be reasonably assured
                                                           page7
   MLP continued
 What are executory costs?
Payments to the lessor to reimburse him/her
for operating costs like repairs and
maintenance or insurance

 Are they included in MLP?
    NO!

                                              page8
   Minimum Lease Payments
What is a bargain purchase option?
  An option to purchase asset at end of lease term at
  a price sufficiently below expected market value that
  exercise of option appears reasonably assured


What is the MLP for leases with a BPO?
    PV of rental payments and the BPO at the
    end of the lease term.
                                                          page9
 Capital Lease Example

 6-year lease
 Annual payment due at year end = $18,287
 No BPO and legal title does not pass at the
  end of lease term
 FMV of leased asset = $75,185
 Economic life of asset = 10 years
 Appropriate interest rate = 12%
 Est. salvage value = $3,185
                                            page10
 Present Value of MLP
 $18,287 $18,287 $18,287 $18,287 $18,287 $18,287


   1       2        3       4       5       6


PV = $18,287 x PVIFA(n=6, r=12%)
   = $18,287 x 4.11141
   = $75,185
                                            page11
    Lessee Journal Entries
   Inception of lease: record leased
    asset and lease obligation at present
    value of MLP
   Record payments
   At period end accrue:
       depreciate asset
       record interest expense



                                            page12
  Inception of Lease Term
JE to record leased asset and lease obligation
  at present value of MLP?

   leased asset              $75,185
      lease obligation            $75, 185




                                             page13
   Depreciation Expense
On what does the depreciation period
used depend?
 If bargain purchase option exists or
 title passes during lease term, use
 economic life

 Otherwise use lease term
                                         page14
   Basis for Depreciation

What ending values are used for depreciation?
Salvage value if depreciating over
economic life

Guaranteed residual value if
depreciating over lease term

                                        page15
    Record Depreciation Expense
 What is the depreciable basis of this asset?
$75,185 (Salvage value is irrelevant because
the asset reverts to the lessor.)

$75,185/6yrs = $12,531

   depreciation expense $12,531
     accum. depreciation      $12,531
                                                page16
   Lease Amortization Table

Date   Payment   Interest     Reduction     Balance
                            In Obligation
   0
   1
   2
   3
   4
   5
   6
                                                page17
  Lease Amortization Table
                    PV of the min. lease payments


Date   Payment    Interest     Reduction     Balance
                             In Obligation
   0                                           75,185
   1     18,287
   2     18,287
   3     18,287
   4     18,287
   5     18,287
   6     18,287
                                                page18
        Lease Amortization Table
Date Payment (a) Interest (b)       Reduction         Balance
                                In Obligation (a-c)
    0                                                   75,185
    1      18,287      9,022                9,265       65,920
    2      18,287      7,910               10,377       55,544
    3      18,287      6,665               11,622       43,922
    4      18,287      5,271               13,016       30,905
    5      18,287      3,709               14,578       16,327
    6      18,287      1,959               16,328           -1

                                                          page19
  Record First Lease Payment
interest expense ($75,185 x 12%) $9,022
lease obligation                 9,265
            cash                     $18,287


       Interest rate implicit in the lease unless the
       lessee’s incremental borrowing rate is both
       known by the lessor and is lower.

                                                        page20
Lessor Capital Lease Types
   Direct financing leases
       PV of minimum lease payments equals the FMV of
        the leased asset
       No “profit” is recorded; considered to be a
        financing arrangement.
   Sales-type leases
       PV of minimum lease payments less the FMV of
        the leased asset equals the “dealer profit”
       Profit is recognized as revenue at the inception of
        the lease

                                                      page21
        Initial Direct Costs
   Includes costs directly associated with
    negotiating a particular lease
       amounts paid to third parties (e.g. lawyer’s fees,
        appraisal fees, finders fees)
       amounts incurred internally (e.g. time spent
        negotiating lease terms, preparing and
        processing documents)
   Excludes indirect costs (e.g. allocated
    portion of general advertising,
    administration costs or overhead)
                                                    page22
     Accounting for
     Initial Direct Costs
   Operating -         defer and allocate over lease term
                        in proportion to rental income

   Sales-type -        expense in same period as
                        profit on sale recognized

   Direct financing-   add to gross investment in the
                        lease
                        amortize over lease as a yield

                        adjustment
                                                    page23
Example - Direct Financing
 3 year lease
 $20,000 payments due at end of year

 implicit interest rate = 10%

 FMV (lessor’s cost of asset) = $49,737

 initial direct costs = $1,000




                                     page24
     Net Investment in Lease
What is the PV of the MLP (without initial direct costs)?

 20,000 x PVIFA(n=3,r=10%)
    =$49,737 = cost (this is a direct financing lease)



  Do initial direct costs affect this calculation?
Yes, they are added and a new interest rate is found.

                                                     page25
   Impute New Effective Yield
Why add to the initial direct costs?
We want the interest rate the equates the net
investment to the cash flows
$49,737 = -$1,000 + $20,000 PVa (n=3,r=??)

 $50,737 = $20,000 x PVa (n=3,r=?)
 2.53685 = PVa (n=3,r=?)
 by trial and error: r=8.89%

                                                page26
   Ignoring Initial Direct Costs
             payment      interest principal   balance
opening                    (10%)               49,737
yr. 1            20,000     4,974   15,026     34,711
yr. 2            20,000     3,471   16,529     18,182
yr. 3            20,000     1,818   18,182          (0)
total interest income     10,263



                                                   page27
 Including Initial Direct Costs
             payment     interest principal    balance
opening                 (8.89%)                50,737
yr. 1            20,000    4,511   15,489      35,248
yr. 2            20,000    3,134   16,866      18,381
yr. 3            20,000    1,619   18,381            0
total interest income      9,263

 Reduction in income = 10,263 - 9,263
                      = 1,000
                      = initial direct costs       page28
Amort. of Initial Direct Costs

         interest interest
         at 10% at 8.89%     amortization
 yr. 1     4,974     4,511            463
 yr. 2     3,471     3,134            337
 yr. 3     1,818     1,618            200
 total   10,263      9,263          1,000

                                            page29
  Journal Entry

 Entries to record lease:

deferred initial direct costs   1,000
   cash (etc.)                            1,000

lease receivable              60,000
      unearned interest income          10,263
      leased asset                      49,737
                                            page30
   Journal Entries
   Entries to record first payment and
   amortization of income and costs
cash                            20,000
     lease receivable                     20,000
unearned interest income         4,974
     interest income                       4,974
initial direct expense amortization 463
        deferred initial direct costs       463
                                               page31
                               Should the gain
    Sale/leaseback            or loss on sale be
                              recognized when
                               asset “sold” to
              Seller/lessee         lessor?

Sale:                         Leaseback:
Legal title                   seller retains
Transfers                     use of the asset
                              Account for lease
              Buyer/lessor    according to
                              classification tests.
                                              page32
  Sale/leaseback- operating lease
Lessee Retains Right To Use Asset
     defer gains only (losses are recognized
      immediately)
     amortize to rent expense over lease term in
      proportion to rental payments
 Why do you think we defer any gains?
Owners would strike deals where they “sold” the
asset for an inflated price and booked a huge gain on
sale and in return they promised to make
unreasonably large lease payments in the future
                                                        page33
    Sale/leaseback -- capital lease

Lessee Retains Right To Use Asset
   defer gains only (losses are
    recognized immediately)
   amortize to depreciation expense over
    lease term in proportion to
    amortization of leased asset

                                       page34
    “Minor leaseback”

   Lessee Loses Most Rights To Use Asset

   Defined as PV of rental payments is
    10% or less of asset’s fair value

   Recognize gain or loss on sale
    immediately
                                          page35

				
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posted:9/27/2011
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